# Suppose the initial conditions of the economy are characterized by

Suppose the initial conditions of the economy are characterized by the following equations. In this problem, we assume that prices are fixed at 1 (the price index is 100 and when we deflate, we use 1.00) so that nominal wealth equals real wealth.

1) C = a0 + a1 (Y-T) + a2 (WSM) + a3 (WRE) + a4 (CC) + a5 (r)

1’) C = a0 + a1 (Y-200) + a2 (10,000) + a3 (15,000) + a4 (100) + a5 (3)

2) I = b0 + b1AS + b2CF + b3 (r)

2’) I = b0 + b1 (160) + b2 (1800) + b3 (3)

3) G = G

3’) G = 300

4) X-M = X-M

4’) X-M = -100

Where: a0 = 100, a1 = .75, a2 = .05, a3 = .10, a4 = .8, a5 = -500, b0 = 200, b1 = .5, b2 = .5, b3 = -200

Derive an expression for the consumption function and graph it Show all work.

2.

Interpret a2 and a3 (i.e., what do they measure) and why are they so important in terms of measuring the impact of the Great Recession on consumption.

3.

Why is a3 larger than a2?

4.

Derive an expression for the aggregate expenditure curve and graph it on your exam sheet labeling this initial equilibrium output as point A. Also, add this point A to your consumption function.  Show all work.

Draw an aggregate demand and an aggregate supply curve in the right hand graph on your exam sheet identifying this initial point as point A.

NOTE:  We are holding the price level fixed at 100 in this problem. Also, note that you that you cannot derive an expression for the aggregate demand curve, just draw it with a negative slope going through point A.

5.

We now let G rise to 400 as the Federal Government (fiscal policy) authorities are not happy with the level of GDP. Solve for the new equilibrium output and label as point B on all three of your diagrams. Please be sure to label your diagrams completely and show all work.

6.

What is the government spending multiplier in this problem and what does this government spending multiplier depend on?

7.

Suppose, that instead of holding prices fixed as we did in this problem, that prices were perfectly flexible, as in a classical world. Discuss, do not show, how your graphs would be different. Also, comment on what would happen to the government multiplier under the assumption of perfectly flexible prices.

NOTE:  This question is worth 10 points.

8.

Correct and completely labeled diagrams are worth 30 points.

You will need to fill in the following. You may either print out the sheet and complete it by hand, or type in/draw your answers in Word in the document itself.

9.

Pretend you are in charge of conducting monetary policy at the New York Fed and you have the following initial conditions.

Initial Conditions

rr/D = .10

C = 600 b

D = 1200 b

ER = 0

M = C + D

Given the above information (show all work):

Calculate the MB.

Calculate the money multiplier (mm).

What is the money supply (use MS = mm x MB)?

10.

If Rd = 300 – 40 iff, given the information above, what is the market clearing federal funds rate? Assume that this is the target for the federal funds rate.  Show all work.

In the space, draw a reserve market diagram depicting exactly what is going on here! Label the equilibrium point as point A.

11.

Suppose that due to whatever reason, reserve demand changes and you forecast the reserve demand to now be Rd = 260 – 40 iff. In order to keep the federal funds rate at target, what must the open market desk do? Be specific and show this development in your picture on the sheet (label the new equilibrium as point B).

12.

Suppose the alternative, that the open market desk does nothing different, that is, they hold the amount of reserves constant. What happens in the reserve market? What is the market clearing fed funds rate now? Label this development, that is, the new equilibrium as point C. Be sure to show all work.

13.

Let’s go back to the fall of 2008 when we were at the height of the financial crisis. Pretend you are steering the cruise ship and your goal is to keep interest rates steady in the money market.

For simplicity, we hold the price level fixed at 1 and assume that inflationary expectations are fixed at 2%.

Initial Conditions before the fall of 2008

mm = money multiplier = 1.6

MB = monetary base = 1000

Money Demand

Md = P X [ a0 + .5 (Y) – 200 (i) ]

Md = 1 X [ 200 + .5 (3600) – 200 (i) ]

Solve for the money market clearing rate of interest (show your work). Now draw a money market diagram labeling this initial equilibrium in the money market as point A on sheet.

15.

We now experience a shock to the money multiplier so that the new value of the money multiplier is now 0.8. Given that we are in the fall of 2008, what caused such a shock to the money multiplier?

16.

In addition to the shock to the money multiplier as in Question 15, we experience two more shocks that influence the money demand curve: The new, money demand curve is now equal to:

Md = 1 X [ 500 + .5 (3400) – 200 (i) ]

Explain why we would expect this to happen to the money demand function during the fall of 2008. Be sure to discuss both of the shocks to money demand.

17.

Given that your job is to keep interest rates constant at their level in Question 14, what must you do in terms of open market operations given the shock to the money multiplier and the two shocks to money demand? Show all your work on your sheet.

Label this point as point B on the diagram on your sheet.